Calculating the Unit Economics of Your Business
Understanding the unit economics of your business is key to building a solid foundational financial model for your company. Without knowing the unit economics of your business, it can be difficult to determine your company’s current profitability and whether or not changes need to be made in order to improve your gross margins and sustainably scale your business. Think of it as a check-up to determine the true health of your business.
To understand the scalability of your business, you need to calculate your per product (gross profit / margin) and per customer unit breakdown (customer acquisition costs and customer lifetime value). A healthy business is one where the cost to acquire a customer (CAC) is less than the lIfetime value of a customer (LTV).
Considering Your Costs
To calculate the CAC for your eCommerce business, divide your total marketing costs by your total number of new unique customers in a given time period. The equation looks like this:
Marketing costs should include all promotional campaign costs (like display ads, Google Ad Words, and paid social ads), marketing team wages, as well as the cost of your marketing tools and software. If you have a sales team, this would also be included in your marketing costs. As an example, if you spent $10,000 a month in total marketing costs and acquired 500 customers, your CAC would be $20.
Tips To Improve Your CAC
If your CAC is hurting your company’s profitability, don’t fear! At least now you know what’s stopping you from expanding your profit margins.
Increase your on-site conversion rates - You’re investing in marketing activities to drive people to your site, but if you’re not gaining enough new customers to lower your CAC, you need to examine your online conversion rates. Is the number of new visitors to your site increasing? Is the rate of new customer purchases climbing along with your increased site traffic? If not, you need to start testing changes to your eCommerce site: switch up the messaging, post new high-quality product photos, change the size and color of your buy buttons, etc.
Reevaluate the profitability of your various sales channels - If you’re selling on multiple online sites and marketplaces, each has different associated costs and access to different audiences of potential customers. Determine the profitability of each of your sales channels by evaluating which channel costs the most, provides the highest rate of new customers, and has the highest average order value.
Create customer advocates - Wowing your customers with a great experience can create repeat purchases and increase the likelihood customers will tell family and friends about your brand. Word of mouth is one of the most effective types of marketing but also the hardest to earn. For this you need to provide top-notch customer service and a unique and seamless shopping experience. Make customers feel like VIPs with rewards programs that offer special discounts, or try experimenting with packaging - just make sure you watch how it affects your gross margin, as discussed below.
Understanding Customer Lifetime Value
Since it is typically more costly to acquire new customers than it is to keep current customers, you should calculate the average lifetime value of a customer. Knowing the CAC and LTV of your customers can help you determine the ROI of your marketing activities and better understand which sales and acquisition channels provide the best customers. While this may seem like an obvious metric to track, it is often overlooked by many retail businesses. The basic formula for determining the LTV of your customers is:
Note: you can choose a different duration length than the 6 months, just be sure you are consistent.
The metric in this equation that’s typically most challenging for retailers to accurately calculate is the expected lifetime of their customer base. First, you need to calculate the churn rate: take the number of customers you have at the end of a particular time period (E), say the month of April, subtract that from the number of new customers you acquired in April (N) and the amount of customers you had at the beginning of April (S) and divide that by the amount of customers you had at the beginning of April (S). Second, divide 1 by the churn rate. The full equation is Expected Lifetime = 1/[(E-N-S)/S}.
How to Improve Your Customer LTV
To improve the average lifetime value of a customer, you need to find ways to improve each element of the LTV equation.
Increase customer order frequency - If you can increase the average number of purchases your customers make, you can improve your customer LTV. Leverage strategic email marketing, start a loyalty program, or develop a gamified shopping experience to keep your customers engaged. Push timely emails to offer them special discounts, remind them of unpurchased items in their online shopping carts, invite them to events, etc.
Extend the average lifespan of a customer - The longer you can retain your customers, the more value they’ll ultimately provide to your business. How do you elongate the lifespan of a customer? Keep them happy. Offer top-of-the-line customer service, create a positive customer experience across all your sales channels, and personalize their service and products as much as possible.
Upsell - Track what items your customers are purchasing (or considering purchasing) and offer them complimentary items. For example, if you’re selling apparel and a shopper is looking at a pair of gloves on your site, highlight a bundled offering that includes that pair of glove along with the matching hat and scarf. And if you offer that bundle at a slight discount, shoppers will be even more compelled to buy those three items instead of just the gloves.
Optimizing Your Gross Margins
Since your gross profit margins ultimately determine whether your business fails or succeeds, it’s paramount that you not only understand your profit margins, but are constantly working to optimize them. Typically, eCommerce businesses have gross margins of about 20-50%, with the exception of resellers who operate with thinner margins but higher volume.
To calculate your gross profit, use the following equation: Gross Profit = Total Revenue - Cost of Goods Sold. And to calculate your gross margin use this equation: Gross Margin = Gross Profit / Total Revenue.
Your costs of goods sold include costs you pay your supplier or wholesaler or the cost of materials and labor needed to make your products, shipping and packaging.